How to auction thin air

The recent media reports in Jan 2022, of Indian telecom operators requesting the government for reduction in base price of 5G spectrum auction by over 90%, had me thinking about the financial distress of these operators. While a lot has been written on the topic in media, and experts point to some obvious reasons, I was not satisfied with the answer I found to the following question: Are high spectrum prices arrived at through auctions by the government, the reason for the financial dire straits in which telecom operators find themselves in?

The Undercover Economist a book by Tim Harford, which I came upon recently, had an interesting perspective on spectrum auctions, I would like to share here:

Auctions are the preferred route to arrive at the value of telecom spectrum licenses worldwide. Many countries and their governments have earned windfall revenues through the spectrum auction process. Some governments have earned less than anticipated revenues too. But the auction route remains the best mechanism to discover the value of thin air (telecom spectrum) as the UK government discovered when it auctioned 3G telecom licenses in 2000. In the rapidly evolving world of mobile telephony, the objective of the government is that a valuable public asset such as spectrum, should go to capable companies with technology know-how to deliver the best quality telecom services at the lowest price. To discover the value of spectrum, an auction is the most transparent mechanism whereby competition between bidders ensures that the government (the seller) gets the best possible price for a public asset. The UK government adopted a model of continuous online bidding for 3G auctions.

For simplicity imagine a straightforward auction of a single license, which is like a traditional auction where bidders yell out higher and higher offers, with one difference: anyone who stays in the room is presumed to be willing to pay the current high bid. Anyone who drops out must leave the room and not re-enter. Each bidder must make a judgement about the license's worth. When the auction starts and prices begin to rise, bidders will start to drop out once the asking price for the license exceeds their own estimate of its value to them. Bidders without confidence in their business plans and technologies will be the first to go. If the price rises a long way without anyone leaving the room, each bidder learns that the others are confident about the prospects for the telecom market as a whole. If some bidders leave early, the rest should take note and revise their assumptions. No company will drop out while the price is still lower than their prediction of the license's value, and no company will keep bidding once the price rises too high. The auction summarizes the collective wisdom of all bidders. Moreover, the auction collects the best price for a public asset. The UK government's 3G auctions used a similar auction process which saw participation from 13 companies. The initial expected collection was ￡2-3 billion, but after 93+ rounds of continuous online auctions the total revenue of the UK government topped ￡29 billion! By all estimates, the UK government outdid itself.?Companies bidding in the spectrum auctions were willing participants in the process, and the transparent nature of the auction was designed to spread information around, so all bidders looked at the same facts and their bids at each stage of the auctions reflected their estimate of the viability of the business. The bidders who withdrew from the auction sent a signal to other bidders, that the licenses were not worth a higher bid. In turn, the ones who stayed in the auction signaled their confidence that the licenses would prove hugely valuable.

The 3G auctions in UK thus proved to be a transparent mechanism for price discovery of a public asset.

The high auction prices were set by willing companies bidding for scarce spectrum licenses. However while the UK govt expected up to ￡ 3 billion in revenue from the 3G auctions, the actual realisation of ￡ 29 billion exceeded expectations almost 10 times over. The excess of ￡ 26 billion in my opinion can be attributed to phenomena called herd mentality.

Here is my inference of how herd mentality worked in the telecom auctions: In the auction process since all price and information was available to all bidders, after the threshold of minimum financial viability of the business had been breached; each bidder began second guessing the other. If X thinks, Y who is a worthy competitor in the auction has bid a higher price than X, he may think what's good for Y is good for himself too. Once this thinking sets in, each bidder tries to better the other's bid price, throwing caution to the wind - this is when Fear of Missing Out (FOMO) sets in. This process continues till the weakest bidder in the process realises that he/she is out of his/her league in terms of bid price. Once the weakest drops out of the process, it signals the remaining bidders to rethink their bids. As the financially stronger bidders keep raising their bids, the financially weaker bidders exit the auction one by one. Finally, the prestige phase sets in, among the strongest bidders. At this stage more than ever emotions are at play, to get the spectrum license at all costs. As a result the winner of the license also carries the weight of unenviable debt, even before the first customer has come on board.

The 3G auctions in India in 2010, ensured the government revenue of INR 70,000 crore - double the amount it expected to collect. Herd mentality played out in the auctions with 9 leading mobile operators going all out to outbid each other for spectrum license. In addition cut-throat competition for market share resulted in telecom operators slashing data prices to the lowest in the world, further pushing back the timeline for financial viability of their businesses.

Human beings in the evolutionary timeline, have survived and progressed from being roaming hunters and gatherers to setting up farming communities and fueling the growth of industrialised cities, as a result of cooperation in society at large. Herd mentality helped creation of cities and development of large projects for the common good and progress of human society. However herd mentality also pushes up asset prices to irrational levels (e.g. IPO frenzy in Indian markets in 2021), creates fads (e.g. dutch-tulip mania in 16th century), triggers financial crisis (e.g. US housing bubble which triggered the great financial crisis of 2008) and sustains ponzi schemes which promise unrealistic returns and many more.

Herd mentality is a behavior wherein people tend to react to the actions of others and follow their lead. This is similar to the way animals react in groups when they stampede in unison out of the way of danger—perceived or otherwise. Herd mentality is distinguished by a lack of individual decision-making or introspection, causing those involved to think and behave in a similar fashion to everyone else around them (think about the rush at year end clearance sales at popular retail outlets near you). Because this type of behavior is instinctual, those who don't succumb to it can often feel distressed or fearful. If the crowd is generally going in one direction, an individual may feel they're wrong by going the opposite way. Or they may fear being singled out for not jumping on the bandwagon.

We all cherish our individuality and insist that we take responsibility for our own welfare by making decisions based on our own needs and wants. But it is natural for human beings to want to feel as though they're part of a community?of people with shared cultural and socioeconomic norms. So it shouldn't come as a surprise to find that it's just a part of human nature to follow the crowd.

However in personal finance, every individual’s life situation is different, risk profiles and cash flows vary. Trying to follow the crowd may not always work. Consider the following points before following the herd:

• Stop relying on others to do the research
• Do your due diligence before making an investment decision
• Don’t be afraid to question other’s decisions
• Delay making decisions if you are distracted by emotions
• Don't be afraid to stand out from the crowd

Herd mentality is a short-cut route many of us follow while working on our personal finances and it works on the philosophy of “If it works for my neighbor, it works for me too”. Following the herd is a recipe for bad investment decisions, especially if you haven't done your own research and let your emotions get the better of financial prudence, as the telecom auctions have shown.

Source: the undercover economist by tim harford

Author: Ashish Joseph George, MMS, CFP. The views shared in this article are my personal views and don’t reflect the views of any organization. This is not an investment advice